Over-the-Counter (OTC) Market

Over-the-Counter (OTC) Market

Over the counter (OTC) markets denote markets where transactions take place directly between counter parties. It is opposed to organized exchanges where transactions are intermediated by an official organization (the stock exchange in equity markets, the clearinghouse in future markets).

An important difference is that while organized exchange trading are often orderdriven markets as the direct confrontation between supply and demand for assets lead to the determination of their price, OTC markets are quote-driven markets (O’Hara, 1995).

Dealers first determine and announce through electronic systems, like Bloomberg or Reuters, the prices at which they are ready to buy (bid price) and to sell (ask price) the security, and then the client, who can be another dealer, decides whether to make the deal.

For the dealer to earn money, the ask price is always above the bid price. Generally, quoted prices are indicative only, and better conditions, that is, inside the bid-ask spread, can be obtained during the deal.

This used to be the way trading was taking place in spot and forwards foreign exchange or bond markets. Stocks are usually traded on exchange markets. However, OTC markets exist for stocks with limited liquidity or for the exchange of large quantities (block trades) for which they are reputed to be more efficient in terms of transaction costs. By definition, futures trade on their original markets.

OTC derivatives are generally documented through a master agreement, which sets out the standard terms that apply to all the transactions entered into by both parties. This prevents from renegotiating the terms at each new transaction.

Historically, a standard way to distinguish between organized and OTC markets was to consider that the former are centralized with a precise geographical location while the latter are fragmented.

With the advent of electronic platforms covering FX or bond markets, this line of separation has become meaningless. What remains, though, is that transactions remain private in nature (for instance, identities involved in the transaction are not disclosed to other participants).

As transactions are bilateral, counterparty risk used to be very significant in OTC markets, at the difference for instance of future markets where the clearinghouse ensures that financial obligations will be met. This does not mean that OTC markets are totally deregulated.

For instance, in OTC derivative markets, International Swap Dealers Association (ISDA) edicts typical agreements that are used to help standardize and improve the transparency of transactions. In practice, this leads to mitigate the differences between organized and OTC markets.

Trading in OTC markets implies complicated strategic effects and search costs. While informed investors are assumed to face larger spreads as dealers try to protect themselves (Glosten and Milgrom, 1985), large investors can at the same time benefit from better prices as they offer access to outside options based on their ability to trade with other investors or market makers.